Short Bear Ratio Spread
The short bear ratio spread is an advanced strategy that's constructed to generate profits from the price of a security falling in value. It's essentially an extension of just buying puts (the long put), in that it can provide a high return on investment if a security does fall in price, but it allows you to reduce the amount of capital you need to invest.
Although it only requires you to make two transactions, it isn't exactly a simple strategy. It's a ratio spread which means one leg is created at a higher ratio to the other leg. In this case, it involves buying more puts than you write. We have provided detailed information below.
The Key Points
- Bearish Strategy
- Not Suitable for Beginners
- Two Transactions (buy puts & write puts)
- Little to no upfront cost
- Medium Trading Level Required
- Also known as Short Ratio Bear Spread, Short Ratio Put Spread
Why Use This Spread?
The short bear ratio is a good choice of strategy when you are expecting the price of a security to drop sharply, but want to reduce the upfront costs of establishing a position where you can profit from this. The potential for profits is limited only by how much the security can fall in price (just like the long put), but the cost of buying puts is greatly reduced by also writing puts.
The trade-off is simply that you make returns at a proportionately lower rate as the price of the security falls. It's a strategy that you should probably use if you are expecting a security to go down in price, but have some concerns that it may in fact go up in price and want some protection against that happening.
Applying the Short Bear Ratio Spread
To establish this spread you need to make two transactions. These can be made simultaneously, or you can use legging if you are comfortable doing so. You need to buy puts using the buy to open order and also write puts using the sell to open order.
The contracts should be based on the same underlying security and have the same expiration date, but the ones you write should have a higher strike than the ones you buy. The number of contracts that you buy should be greater than the number of contracts that you sell, at whatever ratio you think is best.
As a guideline, a commonly used ratio is 3 options bought for every 1 sold. However, it ultimately depends on what you are trying to achieve. The higher the ratio, the higher the potential rate of return, but the more the spread will cost you. You also need to consider what strikes to use; the closer the strikes of the two legs, the more potential profits you will make.
It's ultimately your decision as to what ratio and strikes to use, but a good general rule is to use a 3 to 1 ratio and to buy at the money contracts while selling contracts that are a few dollars in the money. You want to try and get the upfront cost as close to zero as possible.
Potential Returns & Losses
The amount of profit you can make limited only by how much the underlying security can fall in price. This strategy will return a profit providing the price of the underlying security falls by enough to make the total value of the options you own are worth more than the total value of the ones you have written.
Assuming you have used a 3 to 1 ratio, you will need the value of the ones you own to be worth more than one third of the value of the ones you have written. This sounds more confusing than it really is, because you will see from the example we have provided further down the page.
The potential loss of this strategy is limited; you'll make the maximum possible loss if, at the time of expiration, the price of the underlying security is equal to the strike of the options bought. In this scenario the options you own will expire worthless, but the ones you have written (with a higher strike) will be in the money and give you a liability.
This strategy has a characteristic that is quite rare for a bearish options trading strategy in that you'll actually be in a better position if the price of the underlying security rises dramatically, then you will be if it only rises a little bit. This is because if the price of the underlying security goes above the strike of the put options written, then they will also expire worthless, and your losses will only be any initial investment made.
This is a good reason for trying to get the initial investment required as close to zero as you can.
Benefits & Drawbacks of the Short Bear Ratio Spread
The main benefit of this strategy is that you can make virtually unlimited profits if the price of the underlying security goes down sufficiently, but if the price should unexpectedly go in the other direction your losses will be limited. The biggest risk is if the security remains relatively stable in price, you can lose your investment in the put options you buy, but you will incur a liability on the ones you write.
The other benefits are the flexibility the spread offers, and the relatively low (or even non-existent) upfront costs involved. In terms of drawbacks, it's a complex strategy and you need to get your calculations accurate to get the most out of it. It's also not as profitable as the long put, but the upfront costs are lower.
We have provided an example of the short bear ratio spread below, to show how it can be implemented and what some of the potential outcomes are. We should point out that this example doesn't use real market data, and the options prices are hypothetical. Broker commissions haven't been taken into account.
- Company X stock is trading at $50 and you expect a strong decrease in the price.
- At the money puts on Company X stock (strike of $50) are trading at $2 and in the money puts on Company X stock (strike of $55) are trading at $6.
- You buy 3 put options contracts with a strike of $50 (each contract containing 100 options) at a cost of $600. This is Leg A.
- You write 1 put options contract with a strike of $55 (each contract containing 100 options) for a credit of $600. This is Leg B.
- You have created a short bear ratio spread and the upfront cost is zero.
If Company X stock decreases to $47 by expiration
The puts you own (those in Leg A), will be worth approximately $3 per option, for a total of $900. The ones you have written (those in Leg B) will be worth approximately $8 per option for total of $800. Your profit will be approximately $100.
If Company X stock decreases to $45 by expiration
The puts you bought in Leg A will be worth around $5 each (a total of $1,500). The ones you wrote in Leg B will be worth around $10 each (a total of $1,000). Your profit will be roughly $500.
If Company X stock remains at $50 by expiration
The puts you bought in Leg A will be worthless. The ones you wrote in Leg B will be worth around $5 each for a total liability of $500. Your loss on the trade will be around $500.
If Company X stock increases to $55 by expiration
The puts you bought in Leg A will be worthless, as will the ones you wrote in Leg B. With no initial cost, you will have roughly broken even on the trade.
If the stock rose any higher than $55, then the result would be the same and you would be about break even. If the stock fell any lower than $45, then your profits would increase further.
Profit, Loss & Break-Even Calculations
- Maximum profit is limited only by the amount the security can fall in price.
- Profit made is “((Strike Price in Leg A – Price of Underlying Security) x Number of Options in Leg A) – ((Strike Price in Leg B – Price of Underlying Security) x Number of Options in Leg B).
- If you incurred a net debit when creating the spread, you would have to deduct that from your profits.
- Maximum loss is limited.
- Maximum loss is made when “Price of Underlying Security = Strike Price of Leg A”
- Maximum loss is “(Strike Price in Leg B – Price of Underlying Security) x Number of Options in Leg B”
- If you incurred a net debit when creating the spread, you would have to add that to your losses.
- The break-even points will depend on the ratio used, the upfront costs (if any), and the strikes used. You should calculate the break even points yourself and the time of applying the spread.
This strategy is definitely worth considering as an alternative to the long put if you are expecting a security to fall in price significantly, particularly if you have some concerns that the security may not perform as expected and go up in price instead. It isn't without its risks, but these are relatively low compared to the potential profits that can be made.
Experienced traders that are comfortable working out optimal ratios and strikes should certainly think about using this strategy when appropriate, but we would advise beginners to stick to the simpler strategies.